Saturday, May 16, 2009

The Great Commitment of President Obama

By THOMAS L. FRIEDMANPublished: April 7, 2009

I am really encouraged by President Obama’s commitment to clean energy and combating climate change. I just have three worries: whether he has the right policies, the right politics and the right official to sell his program to the country. Other than that, things look great!

Here is another one in my long series "The case for fuel tax". I believe that a massive revenue neutral gas tax holds a tremendous potential to address not only almost all major challenges facing America and the West in the first half of the 21st century. Such a tax has a potential to change the world. Here I am going to examine the tax's effect in the most immediate term. For analysis of the tax's long term implications, see my earlier posts on the subject.

It's interesting that Friedman has by now changed the tactic and started arguing that incremental and delayed implementation of carbon tax can be just as effective as an immediate tax. This is absolutely correct. The purpose of such a tax is to shape anticipations, immediate economic incentives matter less. I was actually making a very similar point here. However, since then I have changed my mind as I came to be believe that an immediate and massive gas tax introduced by means of a tax swap can immediately benefit US taxpayers and the economy. It's precisely now, during recession, that such a tax reform should be considered. Here is why.

The standard microeconomic theory of tax incidence holds that regardless of where a tax is collected, unless we are dealing with totally inelastic supply or demand, tax burden is split between producers and consumers. Here is a graph illustrating this concept.

I provide here a modified graph. The original retail price of gas is $2 to gallon. A $1 gas tax is imposed. The retail price of gasoline rises to $2.5 per gallon. The loss is split evenly between producers and consumers, but the government fully refunds the consumers by repaying them back $1 collected on each gallon. According to this graph, such a tax swap ends with redistribution of wealth between consumers and producers benefiting the former.

In terms of wealth redistribution this means taking dozens of billions of dollars from oil producers and putting them straight into the pocket of US consumers. And when we are talking about oil producers we are talking very much about Saudi Arabia and other OPEC members. Of course, there exists an issue of demand elasticity, widely claimed to be pretty inelastic when it comes to carbon fuels, against the global energy market which for smaller nations should appear as absolutely elastic on the supply side. However, practical experience and common sense can easily send these two arguments packing.

For one, the recent experience shows that the demand for carbon fuels in the US is elastic enough with the breaking point somewhere between $3 and $4 per gallon. This was amply evident a couple of years ago when sells of hybrids and flex engines shot up. In those states that took matters into their hands the impact was even more dramatic with tax revenues collapsing as a result of collapse of demand for carbon fuels. Two, the US is no marginal oil consumer and producer. It accounts roughly for one quarter of global oil consumption and even more in terms of oil imports. It's twice as much a swing oil consumer as Saudi Arabia a swing oil producer. Of course to cut oil consumption is absolutely not the same as to cut production. Nevertheless, any move in US oil inventories tends to send the price of oil in the opposite direction.

It's easy to see from these three charts by how much the US is more a swing energy consumer than Saudi Arabia is a swing energy producer. While there may be a certain validity to the claim that demand is inelastic, in practical terms it only means that consumers take a loss equivalent not to 50% of a possible tax, but say 70%-80%. On the graph above this would be expressed as the retail price stabilizing at $2.7-$2.8. Given that taxpayers should be fully refunded for this loss through a tax swap, they just benefit less from the reform, but they still do, they don't lose. Ironically, it also means that for the gas tax to benefit the taxpayer most, it should be massive enough to put maximum pressure on the price.

America's irrationality on everything related to taxes is amply demonstrated by Friedman, Krauthammer and other supporters of the gas tax themselves. Instead of clumsily arguing that gas tax does not hurt so much, they should better blatantly tell their compatriots to have mercy on themselves and their purse and let themselves save a few dollars at the expense of oil sheikhs. For the US the gas tax is a bit like skiing. America should overcome its deeply ingrained fears by taking a plunge. It should do the opposite of what its natural fear dictates it and throw itself into it.

Some people may say that it's not right to manipulate markets, in particular, manipulating them in such ways that discourage markets from more productive modes of production. Without starting a debate about the religion of free markets and whether the markets are so sacred that they should not be manipulated, I would dismiss this whole argument as irrelevant. I have already dealt with this point here. To put it short, it's the current system that manipulates the markets. The gas tax is more like demanipulation. It's corrective and not manipulative.

Of course, the current administration has its own reasons for shunning any discussion of gas tax. For starters, Obama has repeatedly stressed his non-partisanship and called on both parties to work together. So it's only natural that he is now pushing for the cap and trade scheme that's not only absolutely unacceptable to the Republicans, but is hopeless with large chunks of his own party too. Two, Obama claimed that it's not right to slap taxes on the middle class in recession. That's why the tax swap, immediately beneficial for taxpayers, was dropped in favor of what so many, and probably correctly, suspect of being a hidden tax. Finally, gas tax is a simple and effective way to cut on oil consumption and reduce US dependence on foreign oil, but this cannot be said about the cap and trade program. For Obama this is sure yet another point in favor of the cap and trade. In short there is a certain failure here to follow public declarations with a correct practical decision. Other than that, I tend to agree with Thomas Friedman: Obama's commitments are truly impressive. Things look great. All that's missing is only right policies, right politics and right officials.